Performance fees have become less relevant in Canadian asset management during the past decade.Nathan Denette/The Canadian Press
When an asset management firm is sold or seeks investment, buyers prioritize predictable earnings.
In most transactions, valuation focuses on fee-related earnings (FRE), which are recurring profits from management fees charged as a percentage of assets under management (AUM). These earnings are stable, transparent and highly valued.
Performance fees are earned only when an investment strategy exceeds a set benchmark, often subject to a high-water mark. They can boost profitability significantly in strong years, but may not be earned during weaker periods.
As a result, performance fees are typically excluded from FRE and instead included in distributable earnings, which is similar to normalized EBITDA. These earnings capture all cash-generating profits, both recurring and episodic.
That distinction is where most valuation debates begin.
Why performance fees sit outside fee-related earnings
Performance fees have become less relevant in Canadian asset management during the past decade. In conventional active strategies, especially long-only mutual funds and exchange-traded funds, they’re now largely non-existent.
Two factors drive this shift. Fees have declined by about 24 basis points over the past decade, according to Morningstar Inc., because of the rise of passive investing and the challenge of consistently outperforming benchmarks. Consequently, Canadian fund managers find it harder to justify performance-based compensation, reducing the prevalence and viability of these fee structures.
As a result, FRE is now the primary driver of value for firms managing conventional funds that invest in public markets.
In other segments, performance fees remain central. The growth of liquid alternative funds, following 2018 changes to National Instrument 81-102 that allowed mutual funds to use short-selling, leverage and derivatives, has increased AUM in these strategies to more than $60-billion. Evergreen private market funds have also proliferated, often with performance-based fees included.
In these funds, performance fees can constitute a significant portion of distributable earnings, sometimes accounting for 10 to 40 per cent of total profits in strong years.
However, performance fees don’t always translate into higher valuation in a transaction.
Buyers pay for certainty, not potential
For buyers, the distinction between FRE and distributable earnings is primarily about certainty.
FRE is recurring and linked to AUM directly. Performance fees are contingent, often volatile and influenced by market conditions, timing and investment skill.
Performance fees also introduce additional risks. Revenue can be inconsistent, with periods of limited realization followed by strong years. Fees are often tied to specific portfolio managers, increasing key-person risk, and can disappear if performance declines.
Therefore, most acquirers assign limited or discounted value to performance fees unless there is clear evidence of consistency and repeatability across cycles.
When performance fees are considered, three main valuation approaches have emerged:
- The first treats performance fees separately using a discounted cash flow analysis. Future performance fees are projected but with a high discount rate, often more than 30 per cent, to reflect their uncertainty. This typically results in a present value that is materially lower than what sellers may expect.
- The second incorporates performance fees into distributable earnings, but applies a significant discount to the valuation multiple. Typically, performance fee earnings are valued at about half the multiple used for FRE. For example, if FRE trades at 10 times, performance fees may be valued at 5 times.
- The final approach normalizes historical performance fees over a longer period, typically five to 10 years, to smooth volatility and establish a defensible earnings baseline. A discounted multiple, relative to FRE, is then applied to reflect lower certainty while recognizing realized historical performance.
Often, even when performance fees are credited in valuation, a gap remains between buyer and seller expectations. Earn-outs are commonly used to bridge this gap. By tying part of the purchase price to future performance fee realization, sellers can benefit from upside while buyers gain confidence that they are paying for actual earnings.
Ultimately, valuing performance fees is less formulaic than valuing recurring revenue. The appropriate approach depends on the consistency, structure and visibility of these fees and can vary significantly between firms. Judgment and experience are essential to achieving the right outcome.
Firms preparing for a sale should clearly separate FRE and its growth as the core value driver. Performance fees should be presented transparently within distributable earnings, emphasizing multi-year consistency over peak outcomes. Sellers should also expect earn-out structures to be standard in negotiations.
Performance fees do have value and, in the right circumstances, can enhance a firm’s economics and support valuation. However, they’re not treated as equivalent to recurring revenue. Buyers pay a premium for growth that’s predictable and repeatable. Performance fees receive similar treatment only when they’re consistently realized and can be reliably underwritten.
Joe Millott is a partner at Fort Capital Partners, an independent investment bank that specializes in wealth and asset management mergers and acquisitions, with offices in Vancouver, Calgary and Toronto.